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At Georgia Tech professor Mulford has made available some great resources.
The spreadsheets with trailing data for various industries can help you back-up your valuation assumptions or provide benchmarking data.
Why do industry averages matter?
The pervasive effect of reversion to the (industry) mean is stronger than many good competitive positions as barriers to entry tend to get broken down. On the positive side, terrible businesses generally get a break when better management comes in. Terrible industries profit when raw materials become cheaper or technology makes capex less burdensome. As a result both negative and positive ROIC’s tend towards their cost of capital.
Extrapolating a firm’s current margins and asset turnover is a capital mistake.
Change in Median ROIC by Quintile (2000 to 2010)
What can you find?
Per industry data on:
- Operating cash margins
- Free cash margins
- Net margins
- Cash as % of revenue
- SGA as % of revenue
- Cash cycles
- Receivable cycles
Follow the link, use and enjoy!
Custom-made shoes to fit your feet? Live in the shop?
In this presentation Century Management’s founder Arnold van den Berg explains why 3D printing is going to lead to an improvement in productivity and how this increased productivity leads to wealth creation. But this time, I believe the consumers will benefit.
The Wealth Creation Cycle according to Century Management
Century Management’s definition of Wealth
Obsolete manufacturing facilities
The drawbacks of this coming whirlwind of change to manufacturing companies is job losses and obsolete manufacturing facilities. Even though in Europe and the US many manufacturing jobs were outsourced in the last decade, there are still many plants left, employing still significant numbers of low-skilled laborers.
For example, what will happen with a bicycle factory in France which is now protected by EU import barriers against cheap Chinese bicycles?
If it doesn’t want to lose out against competition, it will have to start buying 3D printers, hiring engineers and designers and will have to start closing factories, firing production line workers and set up 3D printing hubs in every corner of the country, perhaps in every other bicycle shop.
Competition will be higher, competitive advantages short-lived
However as 3D printers will become cheaper every year, competitors will start appearing and key competitive battlegrounds will be intellectual property, safeguarding access to the latest 3D printers, materials, retaining the best engineers and most original designers and have a fine-mazed distribution network (bicycle shops with production facility?)
This will lead to very thin profitability margins and business models being turned upside down, there’s no EU import barrier to prevent this development.
What does this mean for investors?
After the technology sector, the heavy capital intensive manufacturing sectors will have their business models constantly turned upside down.
Owning a traditional factory could very well turn into a liability as competition turns abundant and profits turn into losses.
Subsequently fixed assets will have to be impaired and the debt used to finance these assets will be uncovered, leading to restructuring and losses for equity holders.
But debt is not the only liability, think expensive pensions, severance pay for redundant employees and more. Remember what happened to US car manufacturers with uncompetitive labor costs and obsolete car models?
Who will profit from this productivity gains?
For investors, productivity is a great gain, however 3D productivity will not be limited to the company you’ve invested in. It will rather be the new normal and if your company is not flexible enough to adapt…well forget all those stable cash flows you’ve counted on.
So run this scenario when you decide paying for a company’s future cash flows. How will 3D printing affect the business model? How much is current management thinking about or already applying 3D printing techniques?
Thanks to free competition in the end most productivity gains from 3D printing will go probably to the consumer. Manufacturers should prepare for an open competitive landscape and move first to safeguard their competitive position for the years to come.
Beware Myopic Politicians
A significant unknown are protective measures by myopic politicians to avoid 3D competition from destroying jobs. Pursuing this path will lead to temporary job protection, but uncompetitiveness and a dis-incentive to innovate and forcing their citizens to pay more than their peers in other countries. Leaving less money to productively invest in the economy. But unfortunately, career risk is also a strong incentive for politicians to make bad decisions.
See for a sad example Brazil’s expensive clothing prices and inferior textile industries. Ever bought clothes in Brazil? 4 times US prices and inferior quality fabrics. Middle and upper class Brazilians travel to US to buy furniture, electronics, wedding dresses, clothes and more. Hardly a sustainable and fair situation for the country’s population.
Often we read and experience M&A leads to value destruction and complex organisations, because companies are not integrated fast enough, cultures clash and management is not sufficiently involved in the acquisition process.
In a recent study by McKinsey, they identify common critical success factors for value creation in M&A processes. Their findings were earlier acknowledged by Schweiger and Lippert (2005) and Sitkin and Pablo (2005). Although not original I found them quite insightful and wanted to share them with you.
Three factors of key importance:
- After the acquisition performance targets should be set higher than due diligence synergy estimates;
- Reject adopting two cultures approach, also called best of both worlds approach;
- Focused involvement of the CEO in a few critical areas.
1. After the acquisition performance targets should be set higher than due diligence synergy estimates
Expected synergies based on due diligence shouldn’t be targets of the post-acquisition integration process, they should be the baseline because:
- In due diligence processes time and data is highly limited so the identified synergies can be merely considered hypotheses;
- Often synergies focus on the cost side (e.g. staff redundancies) not revenues;
- There’s hardly any focus on the opportunities for growth and sales synergies;
- Due to performance risk, management involved will be inclined to articulate on easy achievable synergies.
Considering this, a careful reassessment of synergies for the forward integration and business plan makes a lot of sense.
Some examples of best practices
Acquirers reset aspirations and build them bottom-up by identifying opportunities to transform the business.
Acquirers build a well documented fact-base to support the development of those opportunities
The common areas of opportunity that need discussion and fact-gathering are:
- Fundamental changes to operations;
- Offering of new products and services to customers;
- Overlap in customer space and suppliers;
- Importing best practices – this realizes synergies 75% higher than expected from due diligence estimates.
Uncomfortable leaders needed!
The target setting process requires leaders to leave their comfort zones and share aspirations. This is highly difficult in the general corporate environment, where managing expectations and avoiding surprises is the modus operandi of successful managers.
A successful technique are off-site workshops, where executives jointly pursue idea generation. End products should be:
- A list of growth opportunities:
- assessment of each opportunity
- ranking them by size and priority.
- A high level implementation plan;
- Additional synergy discovery;
- Cooperative formulation of targets (increasing motivation)
Surely as always there’s a catch. In an ideal world this would work like a dream, however aspirational performance targets require:
- a special breed of managers;
- higher than average sense of accountability (Think 90/10*);
- inspirational and authoritative leadership.
Now attracting these kind of managers and stimulating their behavior takes time and leadership. According to McKinsey, you should first develop this environment before you conduct acquisitions. This is the dreamworld part.
So what should 99% of the company’s do, which don’t have this culture, but see an opportunity to acquire a long time competitor? I’d say buy-in against a large margin of safety, so they’re not overpaying for the hope of synergies they’ll never get. Of course this also sounds more easy than it is.
Special managers require a special culture
If an organization would have the meanwhile the organization should start building a behavioral set of competences:
- Encouraging managers tot take calculated risks
- Giving management confidence to aim beyond original scope and size of synergy targets:
- encourage to develop ambitious business plans
- provide resources to pursue these plans
- Clearly defined managerial roles
- Strong links between individual performance and consequences (+ and -)
- Incentives for high performance – reaching the business plan goals
- Consequences for low performance – 3 strikes and you’re out
2. Asserting control of future company culture is key
McKinsey finds, mergers of equals – or the best of both worlds posture – creates confusion and reduces accountability, hindering integration, lengthening the time of integration, leading to lack of focus on doing business.
To prevent this situation, companies should recognize that one culture tends to dominate.
They should start building a fact-base to identify cultural differences and supporting the integration process. The fact-base should lead to extremely targeted improvements to the company culture, explaining cultural differences clearly and should better help acquired employees understand what to do and how to migrate to the culture of the new organization.
The integration should be managed aggressively, otherwise an unfair playing field will emerge for acquired employees.
A practical example
- Start with survey of: cultural performance, management practices & outcomes
- Identifying different cultural dimensions
- This provides a benchmark on each company’s position and performance
- Discuss this data with integration leaders so everyone understands differences in cultures
- Identify very targeted improvements
- Shape the language of messaging to the merged company
- Develop a Boarding-program to help employees understand how to succeed, performance reviews, financial planning and accountability
3. Focused involvement of the CEO in a few critical areas
During an M&A process the demand on the CEO’s time can be quite overwhelming or too hand-off. The CEO’s involvement should be carefully balanced to have a great process outcome.
The involvement of the CEO is critical for the deal team to remain focused and continue their high energy process. However the CEO should be merely involved in the two areas that matter most, for a couple of hours every two weeks. The remaining decisions should be taken by senior management.
Again thanks to McKinsey for the knowledge sharing, the most difficult part of their advice is overcoming the cultural hurdles to make managers take responsibility for ambitious targets. Career risk is a significant driver for bad decisions and most managers are not risk takers, at least when it comes to their own wallets.
*the 90/10 rule is an approach (which I try to apply) to get things really done. In any circumstance, project, work assignment or else, we should assume 90% of the responsibility and just expect 10% from others.
Some well meant advice, also use Pareto’s 80/20 principle in selecting the 20% activities that add 80% of the value otherwise you’ll drown in work!
Schweiger and Lippert (2005) and Sitkin and Pablo (2005)were both published in the book: Mergers and Acquisitions: Managing Culture and Human Resources edited by Gunter Stahl, Mark Mendenhall.
McKinsey’s findings can be found at http://www.mckinseyquarterly.com/Corporate_Finance/M_A
In an earlier article on this blog, I mentioned ageing is another ticking time bomb under economic recovery in Europe.
Yesterday the Economist has explained quite clearly why this is. Unfortunately they merely mention US data and leave up to imagination how the time bomb could explode, or better yet how it would look when rich world economies implode.
I will make an attempt to illustrate the consequences of reversion. But please remember:
– I am not clairvoyant
– the future could look much different
– no, my name is not Roubini
– and all the facts, data and graphs used are borrowed from the economist.com or other sources.
Baby-Boomers, a bubble deflating
Back to the issue at hand. The baby-boom generation has profited and is still profiting from the demographic dividend. As household and per capita income rose and spending per household decreased, more households were able to save up, invest in pension assets, purchase houses, companies and could stay debt free. Just think: income – spending = saving, and it will make more sense.
Rising numbers of working age (and more work), making more hours and with women entering the labor force all led to higher household incomes. At the same time people had less children, so less household spending lead to more capital to save and invest.
More savings and higher asset prices
For their article, the Economist mentions research by Liu and Spiegel (2011) who found a close correlation between number of middle age cohort (40-49) to old age cohort (60-69) and P/E ratios of equities indicating a larger group of middle aged savers* led to higher P/E ratios. Simply translated: more people saving and investing led to higher stock market valuations…
*People under 35 are often indebted and invest in houses not the stock market.
Sizable political influence, less taxes
Various worrying facts on baby-boomers, profiting from political influence, are also mentioned:
- 7% decline in US federal tax rates alone between 1980 and 2011, yet there was no halt in generous spending on health care leading to exploding deficits
- Eschker estimates that Americans born in 1945 can expect almost $2.2 mln dollar in net transfers from the state
- The IMF finds that Americans aged 65 in 2010 may receive $ 333 billion in net benefits. Source: IMF WP 2011 Intergenerational imbalances
Some anecdotal evidence exists that for European countries the problem is currently even larger. In Italy current workers will pay 14% more pension related taxes than current retirees have paid in their lifetime.
Reversion to the long-run mean
So how would a reversion process look as the demographic pyramid is turning into the shape of a mushroom?
A vicious cycle
Remember the simple equation: income – spending = saving.
As the ratio non-working to working quickly deteriorates, and if mere gradual changes are made to subsidies for the non-working, the workers will have to pay an increasing amount in taxes. This leaves less household income to save and spend.
Just imagine: in France, public sector workers are paid out of the current account. What will happen when 1 pensioner on 10 workers changes into 1 pensioner on 2 workers? Will they cut pensions or raise taxes? Or both? Either way it doesn’t look good for general household income and savings. And France is not the only country with this problem….
Hence my hypothesis that current across-the-board austerity measures (subsidy cuts on daycare, schooling and tax hikes) are the beginning, but certainly not the end.
Increasing taxes, higher current life costs and expected higher future life costs will be a major drag on consumption, depressing employment and company revenues.
In Portugal lowering salaries and cutting back on deductibility of schooling already lead to various families taking their children out of private school and assigning them to free public ones, putting even more strains on public finances.
Less savings, higher costs of capital, lower asset prices
With less savings by the young generations and baby-boomers consuming their savings, less funds are also left to be productively invested in the economy, limiting economic growth and increasing the cost of capital for companies, depressing asset prices.
As P/E ratio’s fall and do not move back to recent historical means, companies will be sold for lower prices than historically recorded leading to value destruction for current company owners and higher required returns on capital by new entrants to justify current prices.
Entrepreneurs currently buying companies should beware that historical valuations and transaction prices are not representative of future exit prices and the opportunity costs of waiting to buy a business are high.
Be careful buying a house now
House prices are just another asset that have changed hands for inflated prices in the last two decades. According to an analyses of the economist houseprices in the Netherlands France and Belgium are 33%, 38% and 42% above the normal rent-to-income ratio and thus still have a steep decline to come.
This indicates the over-indebted generation until 35 are about to become more indebted unless they start withdrawing a larger proportion of their income from consumption and start repaying their debt overhang.
Asset prices would be stable if the generational numbers are stable, however as the baby-boomers are retiring they could decide to move to smaller houses, elderly homes and put their houses up for sale. This is expected to put more pressure on houseprices rather than less.
Often I hear, this time it’s different arguments from real estate buyers or agents, however an illustration on the reversion to the mean in real Dutch houseprices over the centuries leaves nothing to imagination.
Anybody still wanting to buy a house should stop listening to the brokers and perform at least some form of fundamental value analysis (e.g. rental value) or add the expected loss of value to the cost of purchasing vs. renting.
Can economic growth be the answer?
Now back to the macro picture (and the Economist’s storyline).
Economic growth for Europe has become a problematically distant vision and with less savings available for productive investments, this vision is more dream than reality.
Contrary, as costs of capital run up and returns decrease, it is probably natural to expect a period of increased bankruptcies, less jobs like we are seeing now in Spain and Greece.
Also be careful with recent 30 years historical evidence on growth solutions (e.g. Sweden, Finland). They are distorted by EU subsidies, EU accession and a rich world credit boom. Without such a catalyst and even worse, with similar problems in neighboring countries, the recovery will take much longer than historical success stories indicate.
Furthermore as I wrote in an earlier post, economic growth is just not possible as long as Europe doesn’t get on with restructuring its debt and keeps on muddling to resolve a debt overhang and an uncompetitiveness problem at the same time.
Does Austerity help?
Again the babyboom generation is still an electorate of size. Politicians are normal people living from election to election searching for short term solutions and compromises instead of visionary long term solutions.
With Spain’s insiders (babyboomers with fixed contracts) and outsiders (50% unemployed youth) the people paying for the austerity bills are the young. Unable to generate income, they cannot spend, save and become productive members of society. Unfortunately as soon as they find work, they also will have to start paying for the baby-boom bills , higher health care costs and education tuition fees for their children.
In the Netherlands the government recently decided pension funds should calculate their present value of liabilities with an artificial investment rate (UFR), so pension cuts can be avoided at costs for the young. Another indication the balance of power tilts into the baby-boom direction and the bill of austerity will be paid later.
Politicians are almost understandable, let’s not forget, general austerity in Argentina led to overthrowing of various governments in two weeks and an eventual exit of the currency peg, a debt default and loss of savings and pensions. Who in her right mind would want that for her political career?
As long as the young are unorganized, don’t speak up and the pain is far away and spread out, the youngsters are just an easier target for austerity.
Inflation as a solution?
This looks like the easiest way out, decreasing the real value of debt (mostly of younger generations until 35) and decreasing the real value of savings and pensions of everyone, but to a larger proportion that of the elderly as they have accumulated more net assets in pensions, housing and savings.
With the political weight the baby-boomers still bring to the table the question is whether inflation will be accepted and will result in pension cuts or lower pension benefits for the less organized younger generations.
Researchers of the St. Louis Fed, indicate the answer is no. They find as a country ages the tolerance for inflation decreases.
Asset managers beware of inflation!
A large issue also with inflation is the current general regulatory and asset managers consensus, that government debt and high grade credits are the safest assets around.
- Due to this ‘herd’ like consensus the Dutch government bond yields currently at lowest level in almost 500 years
- Corporate bond yields are at their lowest levels since 1958, and just 1.1 percentage point away from their all-time low in March 1946 (2.5%).
- And the current spread between European dividend yields and German bund yields, are at an all-time (320 bps).
Picture: Please not these are stock prices (not yields or P/E levels) versus bond yields.
As soon as inflation will appear on the horizon the ‘herding’ effect will work reversely and take its damaging toll on the average portfolio manager and their average investment portfolios of Credits and Treasuries. Taking away yet another portion of the saved up wealth by (future) pensioners.
Equities and inflation
However don’t consider equities to be a safe haven from inflation either. The evidence on the relationship between inflation and company returns are terrible too.
In a famous article in Forbes (1977) Warren Buffett documented that actually nominal returns are fairly stable over decades at 12% (McKinsey now increases this to 13.5%) and higher inflation decreases realized returns to investors and vice versa. This conclusion is in 2010 again confirmed and explained by McKinsey in their 5th edition of Valuation by Koller, Goedhart and Wessels.
As economic growth seems far away, austerity messes with company revenues levels and inflation will hit savings and pension assets, there’s no overall solution helping us out. In hindsight we will discover what have been the best picks. I have a hypothesis, but I will save that for a later post.
My Conclusion (Yours could be different)
Younger generations should start realizing they are on the losing end of the wealth transfer. Current tax bills are high and increasing, leaving little room to save up for costs of education of their children, healthcare and anything currently subsidized by the state (children’s daycare, elderly homes etc.) Unfortunately also their assets (houses and pensions) decline so they will have to start working harder, spend less and invest smarter.
The baby-boomers will have to be smart as well. Selling they’re company and house now is better than tomorrow and they’ll too will have to eventually count on some harsh pension and subsidy cuts.
Asset managers should finally do away with trying to replicate benchmarks, because the benchmarks have a high chance of trending downwards and consequently the capital they manage. In investing, the case for bottom-up value investing becomes stronger and many investment decisions made based on recent data will prove value traps (remember real estate, banks?)
The differences in wealth between the well-prepared and the average population will become larger (again)…and in general, it looks like the ‘rich world’ should prepare to become poorer…
Aswath Damodaran is one of the key professors teaching valuation. I highly appreciate his approach to knowledge sharing, making his excel spreadsheets, writings and datasets available for free through is resource page at NY Stern University.
Damodaran has now gone a step further making his Valuation Course available online including homework assignments, powerpoints etc. through Symynd.
For people just starting out in valuations or seeking to refresh their memories please consider following this course. For valuation professionals, perhaps tune in later for special topics.
European distressed debt for sale
Baupost of value investor Seth Klarman, together with Centerbridge, Kennedy Wilson and DE Shaw & Co. is in the running for problematic consumer loans of Spanish and Irish banks, het Financieele Dagblad, a Dutch financial newspaper reported early August.
A KPMG report, on which the article is based, mentions:
- these US investors have recently transacted for the first time in Spain and Ireland;
- deal values are within a EUR 400 mln. and EUR 600 mln. range with outliers around EUR 1.5 bn;
- Spanish banks are expected to shed problematic loans of around EUR 10-15 bn. in the upcoming 12 months alone;
- There’s still EUR 1.5 trillion of non-performing loans on European bank balance sheets and KPMG expects these amounts to be offloaded under pressure of Basel III regulations;
- A peak for debt sales is expected around 2014-2015;
According to Reuters, there is a ‘huge’ interest with private equity and hedge funds to buy-up loan portfolios. PWC estimates there’s EUR 65 bn. in capital waiting to be deployed.
Thanks to their continued access to cheap funding (ECB) and hostage to their low capital buffers, European continental banks, until now, have held on to their assets, to avoid the one-off losses selling debt below par.
Baupost and distressed debt experience
So why is this environment interesting to a value investor like Klarman? Aren’t value investors, like Buffett generally interested in low priced stocks to buy and hold?
Well, Seth Klarman is known for his creative approach to value investing and applying its principles in finding any mispriced asset as compared to its intrinsic value. Today Baupost has built up a track-record investing in distressed debt, providing CIT a rescue loan, investing in Lehman’s debt after they filed for bankruptcy and Enron’s bonds after the firm had collapsed. All with extraordinary returns (e.g. Enron: 5 times investment)
Still the news triggered my curiosity as I am relatively unfamiliar with distressed debt markets and Baupost:
- How would Klarman’s team source these more obscure deep value opportunities?
- How would Baupost evaluate this as a deep value opportunity?
- How would Baupost consider the risks and expected returns of this kind of opportunity?
Please note: I am not active in the distressed debt market, nor do I know anyone at Baupost. I did study Klarman’s writings, speeches and interviews, detailing his approach.
How to source these deep value opportunities?
In a 2006 guest lecture at Columbia University Klarman explains how Baupost search strategy is set-up differently than other investment firms. For example Baupost has no telecom or utilities analysts, but has a distressed debt analyst or a post-bankruptcy analyst which evaluate any situation that they come across.
Klarman says, often for distressed debt, Baupost receives calls from Wall street. In 2011 Baupost set-up shop in London to be closer to distressed debt opportunities, however debt sales have failed to materialize, until now.
But is this enough as a search strategy? If the seller hires experienced advisers it is hard to avoid an auction process. Klarman’s ‘Margin of Safety’ philosophy fits better with negotiated sales, so my guessing is, the analysts do not sit around and wait Canary Wharf or ‘The Street’ to call.
How would Baupost evaluate this as a deep value opportunity?
Klarman: “We focus on a bottom-up approach. Finding specific one-off situations that are undervalued. Undervalued because of a specific reason and there’s a catalyst often enough in place for realizing that value.”
Now looking at the opportunities in Spain or Ireland, they are quite clear and fit very well into Baupost’s strategy:
- It’s a one-off situation: quite uniquely banks are shedding valuable assets beyond rational prices. An example: certain banks are canceling service-fee generating, non-drawn credit lines of triple A multinationals. It sounds irrational and it is, hence a great environment for undervalued opportunities.
- The main reasons: an imbalance in supply and demand of capital and liquidity – high demand for capital and liquidity due to Basel III vs. a lack of investor confidence in banks and limited asset sale opportunities.
- Especially problematic credit has become a burden on banks’ balance sheets, because the risk weighting of these assets under the Basel accords will increase and the loss given default (LGD) is uncertain, making regulators jumpy.
- The catalyst for the loans is straightforward. It is the expiration date or redemption of the loans.
What are the key risks and expected returns of this kind of opportunity?
One of Baupost’s key principles is consider the risk first and then the return. Rule #1: don’t lose money. Rule #2: Never forget rule #1. As a follower of Benjamin Graham’s school and as intelligent investors Klarman’s team probably considers three key risks:
- Valuation Risk: an inadequate projection of future earnings
- Business/Earnings Risk: the danger of a loss of quality and earnings power through economic changes or deterioration in management
- Balance sheet/Financial Risk: financial weakness that may detract from the investment merit.
In his seminal work, Margin of Safety, Klarman writes: “There are three principal alternatives for an issuer of debt securities that encounters financial distress: continue to pay principal and interest when due, offer to exchange new securities for securities currently outstanding, or default and file for bankruptcy.”
So the key questions perceiving the risks and grasping potential returns are:
- how to understand and mitigate valuation/earnings/financial risk sufficiently?
- what is the price we can buy this for?;
- what percentage of the debt holders would default or need to be made a restructuring offer?;
- and what % of loans could be recovered in such case?
Of course, this is not easy to determine for me as an outsider, however even being part of Klarman’s due diligence team there probably is sufficient uncertainty about the outcomes.
As Klarman’s says: “Risk simply cannot be described by a single number”, and uncertainty is not risk. Therefore I will make an attempt to qualitatively understand risk and return potential of doing a distressed debt deal.
Clearly a price of 2%-20% of nominal loan value is a significant discount. How much of a discount? That depends on ultimate payoff. Putting in 20 cents on the euro and receiving 30 eurocents still provides a 50% return (assuming no interest payments). However the further away the redemption, the less valuable this transaction becomes.
Valuation risk is also a function of buyers and sellers. As there are still some EUR 1.5 trillion of non-performing assets for sale and little deal appetite at strategic investors, the demand and supply side will be unbalanced for a while. Or?
There are some worrying signals suggesting otherwise:
- KKR (a private equity house): “An insane amount of capital has been chasing the big portfolio sales and the prospective returns will likely be low,”
- When big deals have executed, huge investor interest has, in some cases, forced the prices higher, eating into returns.
- A recent rally in prices is also forcing funds to turn to leveraging to earn the double-digit gains investors expect.
- Even hedge funds not traditionally associated with distressed-debt trading are getting in on the act.
- KPMG indicates that Spain’s market is hottest of all debt sales markets.
Still there is a fundamental an imbalance in demand and supply between EUR 1.5 trillion of assets vs. EUR 65 bn. in capital implying valuations will be favorable eventually, assuming non-performing loans in majority cannot be bought with debt financing.
The loss of earnings power is a clear and present danger in Spain and Ireland, with unemployment at record levels. Due diligence will somewhat clarify whether borrowers have reliable income streams. Naturally not all loan files will be in order and some borrowers will look unreliable on paper, but in fact aren’t. These are the loans with high uncertainty and where Baupost could have the significant edge over the competition.
Baupost could work with local experts for a debt recovery strategy. One of the strategies could be offering an advanced repayment discount to the most problematic cases, hence creating a self-induced catalyst and moving the repayment date forward increasing the IRR and reducing uncertainty.
Moving fast, will mitigate the risks of currency devaluation in real terms or through Eurozone departure, so the majority of cash flows is in Euros not Pesetas.
As per Q2 2012 Baupost has hedged it’s Eurozone exposure several blogs report
Due to the abundance of credit many households and companies in Spain have their debt at unsustainable levels (McKinsey reports: 216% of GDP excl. financial institutions), with all increased risks of default and restructuring.
Again, stimulating firms and households to redeem debts to Baupost first and fast, could mitigate the risk and advance cash flows.
Prices, Returns and Safety Margins
Generally a value investors doesn’t go to work for margins of safety less than 30%. Including the price range (2%-20% of nominal) mentioned in het Financieele Dagblad, this implies recovery rates should be minimally at 30% if investors are to pay 20 cents on the euro. SM: 33% = 1-20%/30%
If Baupost would like to make similar returns as on their Enron investment the average recovery should be around 5x above prices paid, implying realized recoveries of 10 cents for the 2 cent deals. Increasing the recoverability of these loans will have major impact on returns. Vice versa, just as much.
The local experts can detail expected recovery best of course, based on their local data on debt repayments. Of course these databases are based on historical data and correlations change through spillover effects, however it could give a range of probable payoffs.
Time to maturity
If a debt portfolio consists of debt maturing on average between now and 2.5 yrs, the target 5x return would be around 200% p.a. excluding interest payments. However would the payment be moved forward, the IRR (internal rate of return) will increase substantially.
Baupost could even offer debtors restructuring at a higher discount to nominal the faster they respond, taking into account the time value of cash flows and the higher riskiness and uncertainty of cash flows further in the future.
Note the importance of a low price and a rapid and high debt recovery as both risk mitigators, return optimizers and uncertainty reducers.
The current European distressed debt sales indeed offer a good fit with Baupost’s investment strategy. In the competitive European environment sourcing strategy and patience is key to avoid valuation risk.
The EUR 1.5 trillion of assets vs. EUR 65 bn. in capital imply an imbalance in demand and supply, so it still looks like an attractive market in less popular debt segments, leaving room for price negotiations.
The inherent earnings and financial risks can be mitigated by moving fast in restructuring and hiring local recovery experts. Making the eventual returns higher en less risky.
For the interested reader, many great blogs are available on Baupost’s and Klarman’s investments and strategy, a selection:
A summary of Klarman’s guest lecture is available at: http://seekingalpha.com/article/81024-seth-klarman-comments-on-money-management-and-baupost-s-approach
A great blog (unfortunately only in Dutch) on Basel III and risk management is available at:
If you care to buy Klarman’s book. Take a look at:
Anyone of you who is interested in the experience of the most successful value investor in Russia: Bill Browder, and how his success backfired heavily, leading to his prosecution and death of his lawyer. Take the opportunity to see his guest lecture at Columbia University with Robert Heilbrunn Professor of Finance and Asset Management, Bruce Greenwald.
I believe this scenario should be more explicit in our emerging market valuations and not be tucked away in a political risk premium in the discount rate.
Investors and valuation advisers have to consider what happens to valuations if Turkey’s government changes, what happens if Russia will re-nationalize financial institutions, what is the valuation impact of an ‘Arabic Spring’ inspired regime change in Angola, what happens when Greece exits the Euro zone and becomes the Mediterranean Argentina?
See per below a summary of the most interesting viewpoints, tips & tricks I got out of this lecture.
Getting to a proper valuation for an emerging market starts with taking a macro view, working your way down to the micro
- If the macro environment is favorable it doesn’t mean the companies on offer are great investments
- Stop thinking of getting exposure to an emerging market, that’s a sure way of losing money
- Start thinking about identifying undiscovered deep value opportunities – cheap/mispriced assets on an absolute and relative basis
- Privatization programs could offer great value opportunities, but ask yourself:
- Is there an investor friendly government?
- Why is government friendly? What is their incentive?
- Why are oligarchs friendly? What is their incentive?
- How could a change in this incentive and attitude affect your holdings?
- If not friendly? Stay out. Or realize, your market entry is a speculative bet, not an investment
- Is there an investor friendly government?
- Analyze economic fundamentals:
- Is the country a large oil producer? Timber? Diamonds?
- Are there other fundamentals supporting growth?
- Who profits from GDP growth? Don’t automatically assume GDP growth will translate in higher household consumption and revenue growth
- Be skeptical
- Look for fact based analyses to uncover lies
Note from Bruce Greenwald (the interviewer): “..keep in mind that every time you are buying and think an asset is going to perform well, somebody is selling it and one of you is always wrong. Who do you think is wrong when you‘re flying in and they are local?”
Before making any investment, conduct very thorough due diligence on the ground
- Depreciated assets often harbor hidden value, go there, determine reproduction value with you own eyes
- Being a local specialist on the ground gives you a competitive advantage in the valuation process
- Signals of conflicts of interest or worse fraud:
- Find out who owns the company
- What else do the owners do?
- How much do they own?
- How much do they own of other things?
- If you’re investing in an agricultural company and the owner also owns the fertilizer supplier, that’s not a good thing.
- A company that has switched auditors, is not a good thing
- A company where the majority shareholder is a politician
- Do a stealing analyses: Interview customers, consumers, competitors, employees etc. whether there is any stealing going on, check the facts with local registry offices (real estate, land holdings)
- Generally only companies that have stock options tend to overstate earnings, so reported earnings and assets are generally accurate. Implying they are earnings after stealing. Accounting generally counts what’s there.
Once uncovered fraud, what to do?
Fraud, can be also an opportunity: if you can stamp it out, your earnings will increase and so will the value of the companies.
- To get back leaked assets and stolen earnings: involve the press and government in your findings
- Make sure you do all this complying with local and international regulations
- As soon as you get invited for yacht-parties by your clients/investors and get awash with more cash to invest, it’s a sign you should liquidate your holdings (and those of your clients) It’s too much money chasing deals
- Think hard about what your contingency plan is, when relations with government or oligarch relations turn sour. If you see it happening: act fast!
- Think hard about what your contingency plan is, when relations with government or oligarch relations turn aggressive, towards you. If you see it happening: act fast!
Comparative attractiveness of emerging markets vs. free democracies
- Emerging market growth is all fine and nice however there’s huge economic value to fuzzy stuff like democracy and free press, so companies trading in markets without political checks and balances should be bought into against a higher discount than their comparable peers in democratic countries.
- Bill Browder: “…my single biggest lesson learned is that we undervalue what makes America and other democratic countries great, and we shouldn’t, because that plays a real role in valuation and what something’s worth..”
On country diversification:
- Country focus makes you better in knowing all that’s going on, but when political risk becomes unfavorable, that’s the only country you know
- Covering more countries costs more time and effort to figure out what’s going on locally
- However there is a 80/20 rule to this all. With 20% of the effort you can get 80% of the value reasonably estimated. As long as you buy-in cheap enough, and your downside is limited on an earnings or asset basis you can make the investment
Bill Browder on current attractiveness of emerging markets (November 2010)
Bill Browder: “…emerging markets are not attractive on a valuation basis, however they are a bubble about to be inflated due to all the completely absurd money printing that’s going on. We all know this will end in tears, but in the meanwhile there’s money to be made..” Bruce Greenwald’s warning: “…if we try to do what Bill describes it will end in tears for all of us, including Bill, the first time he invested in Russia.”
Disclaimer: this is a limited excerpt of the interview mixed with my personal notes and interpretations. This is not an exhaustive summary. Interpretation errors are mine and the quotes are not a literal transcript of the statements of the speakers. This is no investment advice.
Bill Browder has recently written down his experiences in a worthwile read: